Islamic Finance: Modern relevance of traditional products

Today we will start our study of various Islamic financing products. Our discussion will revolve around their definition and modus operandi and how these products — developed at the time of the emergence of Islam — are still able to meet the requirements of Islamic investors and entrepreneurs in the present age.

Definition of Mudaraba

One of the widely talked about Islamic banking products is Mudaraba. In simple terms, Mudaraba is a form of financing where an investor and an entrepreneur join hands. As per a formal agreement drawn between them, the investor provides funds whereas the entrepreneur uses his skills to earn profit for their joint venture.

Mudaraba or fund management is the original Sharia mode of financing a commercial activity along with Musharika or partnership (to be discussed later). Murabaha, Ijara, Salam and Istisna, among others, are modes of trade which have been modified to serve as financing tools.

History of Mudaraba

The residents of Makkah commonly practised Mudaraba financing even before the emergence of Islam, due to their location at the crossroads of the ancient trade caravans.

Credible Mudarebs regularly carried goods and/or money for many investors at a time and had to be accountable to them. Upon the return of the caravan, the Mudareb used to prepare the Mudaraba account for each investor, enabling him to return the capital along with profit and claim his own share of profit from the investor.

However, in the Islamic era, the Mudaraba was fine-tuned to eliminate some anti-Sharia elements such as making the Mudareb liable for trading losses or theft in transit etc. Also, the dishonest Mudarebs were barred from carrying out the activity.

It is important to note that credibility played a vital role in the selection of a Mudareb. In the small population of Makkah at that time, almost every investor knew every Mudareb and credibility was the key factor in conducting Mudaraba transactions.

Parameters of Mudaraba

The following are the Sharia parameters of a Mudaraba transaction between two parties:

• The transaction must be for an agreed period of time.

• The investor does not interfere in the day to day running of the commercial activity, which is the sole responsibility of the entrepreneur.

• At the end of the agreed period, the Mudaraba account is closed and the profit is determined after accounting for all the expenses incurred in running the joint venture. It may include the entrepreneur's agreed remuneration.

• The net profit is distributed between the parties according to the pre-agreed ratio.

• Capital is returned to the investor upon completion of the Mudaraba period but prior to distribution of profit.

• In case of a genuine loss, the investor has to bear it fully. However, he is not liable beyond the capital amount contributed by him.

• Though eligible to share the profit, the entrepreneur is not liable to share the financial loss if incurred genuinely.

• In the event of loss, the entrepreneur does not have a right to claim remuneration.

• However, if the loss is caused by the entrepre-neur's negligence, he will be liable to return the entire amount of capital to the investor.

• In this situation, the investor can also claim compensation from the entrepreneur for deprivation of the capital in anticipation of profit, which did not materialise.

• The negligence will be considered to have occurred if the entrepreneur is found to have acted outside the scope of agreement entered into by him with the investor.

Let us discuss some terminology. The investor or provider of the capital is called Rubb Al Mal and the entrepreneur Mudareb. Please note that in case of an Islamic bank, the depositors would be called Rubb Al Mal whereas the bank will be considered Mudareb.

When it is the Islamic bank investing depositors' funds, it is called Rubb Al Mal and the entrepreneurs are termed Mudareb. As such, an Islamic bank enjoys the unique position of playing the dual role of Mudareb and Rubb Al Mal at the same time.

(To be continued)

The author is vice-president — Sharia Structuring, Documentation and Product Development, Dubai Islamic Bank, Head Office.